Understanding Perpetual Swaps: The Most Traded Financial Product in Crypto

Perpetual swaps, also known as perps, are a type of trading instrument that has revolutionized the crypto market. They allow traders to gain leveraged exposure to the price of assets like bitcoin without actually owning the underlying asset. Despite their widespread use, the mechanics behind perps are not well understood. To grasp how perps work, it's essential to understand the traditional finance context. In the past, traders used futures contracts to gain exposure to assets, but these contracts had expiration dates and required traders to roll over their positions. The crypto market's early days were marked by persistent problems with futures trading, including a premium to the spot price of bitcoin and the need for frequent contract roll-overs. BitMEX, a derivatives exchange, addressed these issues by introducing perpetual swaps in 2016. A perpetual swap is a derivative contract that tracks the price of an asset indefinitely, eliminating the need for an expiry date and allowing traders to hold positions for any duration. The key to perpetual swaps is a mechanism that ensures the contract price remains aligned with the spot price of the underlying asset. Every eight hours, a payment is made between traders on opposite sides of the market, with the rate of this payment, known as the funding rate, calculated based on the deviation between the perpetual swap price and the spot price. This self-correcting equilibrium prevents the contract price from straying too far from the spot price. Perpetual swaps also offer leverage, allowing traders to control larger positions with less capital. However, this leverage comes with significant risk, and exchanges use automated liquidation systems to manage this risk. Today, perpetual swaps are the primary venue for price discovery in crypto, with regulators exploring their application to traditional assets. The structure of perpetual swaps has proven durable and has become one of the most traded financial products globally.